In many markets, buy and sell orders at the same price are automatically matched. Thus, for example, a first order to buy an item at a price of 100 and a second order to sell the same item at a price of 100 will, in such markets, result in a transaction in which some quantity of the item is sold at the specified price.
But in some markets, most notably the secondary market for U.S. government treasuries, orders of equal price are not automatically matched. Rather, certain types of buy and sell orders, called “passive” orders, may co-exist at the same price without triggering a transaction. These passive orders do not trade unless “aggressed” against by a trader submitting a second type of order, called an “aggressive” order. Historically, a passive order to buy has been referred to as a “bid,” while a passive order to sell has been referred to as an “offer.” By contrast, an aggressive order to sell has been referred to as a “hit,” while an aggressive order to buy has been referred to as a “take” or “lift.”
This distinction between passive and aggressive orders is one of several characteristics of the secondary market in U.S. government treasuries that developed to encourage market liquidity. In particular, since it is impossible to generate liquidity in a market without having someone first make a price, brokers historically sought to encourage traders to submit bids and offers by not charging them a commission if their orders resulted in a trade. Thus, passive bids and offers could not be matched even at the same price since neither the buyer nor the seller would pay commission.
In addition to commission-free trades, brokers in the secondary market for U.S. government treasuries also rewarded passive buyers and sellers by developing a number of trading protocols or conventions which granted passive buyers and sellers certain trading options or “rights.” One such convention is commonly referred to as “workup.” In general terms, this convention permits buyers and sellers to “work up” the size of a trade from the quantity traded as a result of an initial “hit” or “lift.” Typically, certain traders, including the first aggressive-side and passive-side traders, are granted an option or right to increase their size, and to trade that additional size ahead of other traders in the queue.
Another popular convention in the secondary market for U.S. government securities is commonly referred to as “clearing time.” In the clearing time convention, when a passive bid or offer is received in the market that is better in terms of price than the best existing passive order on that side of the market, the trader with the best pending passive order on the opposite side of the market is given priority to aggress against the new order before other traders. If this trader chooses not to aggress against the new passive order within a period of time, other traders with pending passive orders may be given that privilege in certain circumstances depending on the particular version of the clearing time convention implemented. If no trader with clearing time privileges aggresses against the new price-improving order, the new order “clears” and can be hit or lifted by any trader.
Before the advent of electronic trading, voice brokers implemented the clearing time convention by calling those traders with pending passive orders when the brokers received a new, price-improving passive order on the opposite side of the market, and asking them whether they wished to aggress against the new passive order. This practice was colloquially referred to as “clearing to the offer” in the case of a new, price-improving bid, and “clearing to the bid” in the case of a new, price-improving offer. Only after those traders with clearing privileges failed to respond or declined to aggress against the new passive order were other participants permitted to hit or take the new bid or offer.
As electronic trading has become more popular, some electronic platforms have been programmed to provide automated versions of the clearing time convention. In these electronic implementations, the convention is typically implemented by designating the order as “uncleared” and starting a clearing timer for a specified period of time. During the timer's duration, only the aggressive orders of traders with clearing privileges will be executed. Once the timer expires, the order “clears” and may be traded by anyone.
In another aspect of the clearing time convention, when a trader without the current right to aggress against an uncleared bid or offer submits a “hit” or “take” order, this action preserves for the trader the right to do the trade once the bid or offer clears. This has historically been referred to as “hit when” in the case of an aggressive order to sell submitted by a seller without priority, and as a “take when” in the case of an aggressive order to buy a security submitted by a trader without priority. But although the clearing time protocol provides a mechanism by which traders without priority may enter aggressive orders, it does not provide a mechanism by which traders without priority may enter passive orders at prices better than that established by an uncleared bid or offer. Rather, during the clearing time period, other traders wishing to submit such passive bids or offers are blocked from doing so.